#$trow

The best thing to ever happen to investors is only getting better with age.

Wednesday marked the fortieth birthday of the most investor-friendly idea in stock market history: the index fund. Forty years ago Vanguard introduced the first fund that merely tracked the S&P 500. It has appreciated 6,334 percent since inception, trailing the S&P by a mere .14 percent annually, all of which was the ‘expense ratio’ charged investors. Few, if any other funds have matched or exceeded this annual return.

Today roughly $5 trillion is invested in index funds. Vanguard is the largest index manager, with over $3 trillion in assets under management (AUM). Other money managers now offer index products alongside their traditional, actively managed funds.  

Study after academic study shows that index funds outperform most actively managed funds. The reason is simple. Fees. The average expense ratio for actively managed stock funds is around 1.5 percent. It is somewhat less for fixed income funds. As Vanguard founder John Bogle has convincingly shown, a fund with a 1.5 percent annual fee (and the same pre-fee annual return) will produce a much smaller total return over a multi-year period than a fund with a .14 percent annual fee.

Investors have taken notice. According to the Wall Street Journal, they have invested $409 billion in passive index funds in the last year and pulled $310 billion out of actively managed funds over the same period. Roughly 20 percent of all money in stock funds is now indexed, up from zero 40 years ago.  

I suspect this trend will accelerate. America’s economic growth and thus profit growth will likely remain below historic levels for years. Economists predict US productivity growth and population growth will continue decelerating (see Northwestern economist Robert Gordon’s recent book The Rise and Fall of American Growth). Given that interest rates are already at zero, this scenario all but guarantees future market returns will be lower than the S&P’s roughly 9 percent annual gain since the end of World War Two. As this occurs, the outperformance by index funds vs. the average actively managed fund will be much more pronounced than in previous years.  

But don’t expect the asset management world to go down without a fight. A week ago, the reputable money management firm Bernstein issued a call to stem the indexing tsunami. The piece’s sensationalistic title--“The Silent Road to Serfdom: Why Passive Investing is Worse than Marxism”—was obviously meant to attract media attention, and paint Mr. Bogle’s invention in the worst light possible. I’ve seen this kind of scare mongering in the asset management industry for three decades now. When I started out, indexing was still in its infancy, but people in my business were already shading the truth about it, and for good reason: it represented a major disruption to our industry. Rather than acknowledging the clear benefits of that disruption to the majority of investors, many folks have chosen to demonize and misrepresent it instead. As Upton Sinclair famously said: “It is difficult to get a man to understand something when his salary depends on his not understanding it.”

I have always believed that most mutual funds and most hedge funds will underperform the indexes on an after-fee, after-tax basis. Results over the decades prove this. But I have also believed (and continue to believe) that a small minority of managers can, and will continue to outperform. The managers who accomplish this feat employ varying investment strategies, but they almost always possess a similar combination of traits: an above average IQ, some years spent working at firms with above average performance results, intense intellectual curiosity, a cynical frame of mind, and a mistrust of groups and group thinking (great investors are not joiners).

As importantly, consistently outperforming managers almost always avoid growing assets under management beyond an amount where outperformance becomes more difficult. While the optimum AUM varies by manager and by style, it is almost always under $1 billion. Most managers who solicit assets beyond that amount are amoral at best, dishonest at worst. The reason sub-$1 billion funds have a better chance of producing higher returns is obvious: pricing inefficiencies are likely greater in less liquid, less analyzed securities. A number of stocks I have written about over the years illustrate these inefficiencies, including homebuilder LGI Homes and apartment REIT Nexpoint Residential Trust. Both companies were barely followed by Wall Street when I visited with their managements, and far too small for larger funds to bother investing in—and both have far outpaced the indexes since I purchased shares.

I read plenty of stories in the financial media about the coming retirement crisis, but I see far fewer people willing to offer legitimate solutions to the problem of under-saving by the majority of Americans.

Legendary author and investor Charley Ellis put out a book at the end of last year — Falling Short: The Coming Retirement Crisis and What to Do About It — that outlines the issues many are going to face when it comes to keeping up their standard of living in retirement. But the book also offers some solutions for those dealing with this problem.

Ellis laid out the four most important factors that help determine whether or not you’ll have a large enough nest egg to cover your living expenses during retirement:

1. Earnings. The higher our earnings, the smaller the proportion provided by Social Security and the higher our own required saving rate.

2. Age when saving starts. The earlier we start saving, the lower the required rate of saving needed for any given retirement age.

3. Age at retirement. The later we retire, the lower our required saving rate.

4. Rate of return. The higher the rate of return on our investments, the lower our required saving rate.

We have varying degrees of control over each of these. People have the power to earn more money by enhancing their career prospects. The age in which you retire could be affected by poor health or employment issues that force people to retire earlier than they would like, so this one is a toss-up. And no one has any control over the financial market returns that the markets offer (although people do control how much of those returns they earn).

Out of the four, the second option — the age when saving starts — is the one people have the most control over. Ellis goes on to outline a study that shows just how important this one can be over time as you can see the different savings rates required depending on the start and end dates:

The conclusion of the study sums this up nicely (emphasis mine):

Starting to save at age 25, rather than age 45, cuts the required annual saving rate by about two-thirds. And delaying retirement from age 62 to age 70 reduces the required annual saving rate by more than two-thirds— from 17 percent to 5 percent (or 29 percent to 8 percent for those who start at 35, or 56 percent to 14 percent for those who start at 45.) Taken together, starting at 25 and working to 70— compared to starting at 45 and retiring at 62— reduces the required annual saving rate by a factor of 10!

This simple example shows how the power of compound interest can provide the majority of the heavy lifting for you if you’re able to use it to your advantage. William Bernstein shared a similar stat in his book, The Investor’s Manifesto (again emphasis mine):

Each dollar you do not save at 25 will mean two inflation-adjusted dollars that you will need to save if you start at age 35, four if you begin at 45, and eight if you start at 55. Since a 25-year-old should be saving at least 10% of his or her salary, this means that a 45-year-old will need to save nearly half of his or her salary.

You could play around with the rates of return and savings rates in these simulations, but the conclusion is clear that starting to save money at an early age is one of the best things you can do to build wealth. It allows you to save less money overall and lowers the burden on your future self so you aren’t forced to scramble to play catch-up later in life.

One of the best ways to get useful financial advice is to ask those who are older than you what they wish they would have done at your age. A recent study from Wells Fargodid just that. Three out of four survey respondants 40 years of age or older said their biggest financial regret is that they didn’t start saving money eariler. Yet of the non-retirees in that group, more than half said they are still waiting to ramp up their current savings rate to make up for the shortfall. They know where they went wrong, but they still can’t bring themselves to correct the mistake.

As with most financial habits, knowing what you need to do is the easy part. Following through with it is where most people run into trouble.

Sources: Falling Short: The Coming Retirement Crisis and What to Do About It The Investor’s Manifesto

Further Reading: When Saving Trumps Investing A Simple Way to Reduce Portfolio Risk

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This post from Ben Carlson (@awealthofcs) originally appeared on A Wealth of Common Sense.

There’s a fascinating trend happening within the asset management industry where the public is using data and the information available online to make better investing decisions, slowly but surely. There is absolutely zero data that links high fund costs with outperformance over any relevant period of time and the “persistence” data from SPIVA has done a number on the idea that investors who overpay for active management get what they pay for.

Investors are leaving higher cost funds and gravitating toward lower cost funds. I would surmise that the education they are getting on financial blogs and from their advisors is helping to drive this trend.

A new Morningstar study released today shows that the asset-weighted expense ratio across all funds (including mutual funds and exchange-traded products, or ETPs, but excluding money market funds and funds of funds) was 0.64% in 2014, down from 0.65% in 2013 and 0.76% five years ago. The trend is being driven more by investors seeking low-cost funds than it is by fund companies cutting fees.

The data is undeniable: the investor class is learning:

Mutual funds and ETPs with expense ratios ranking in the least-expensive quintile of all funds attracted an aggregate $3.03 trillion of estimated net inflows during the past 10 years, compared with just $160 billion for funds in the remaining four quintiles. That is to say that 95% of all flows have gone into funds in the lowest-cost quintile.

There is an implied link to the fact that service models among financial advisors have shifted dramatically in recent years. There are many more clients now being served by fee-based financial advisors than pure transactional brokers – a trend I have documented laboriously on this site and in my book.

With less brokers, there is the commensurate decline in the type of funds brokers favor (the ones that pay them most). Broker-sold or “load” funds are going the way of the dodo in place of ETFs in wrap accounts or institutional share class mutual funds. Morningstar notes that “Load shares, which charged an asset-weighted expense ratio of 1.02% in 2014, held just 20% of assets as of year-end, down from 37% in 2004.”

The pendulum is not going to be swinging back to higher-cost funds any time soon, contra the opinion of Fidelity’s chief Abigail Johnson. Actively managed funds will either react by rationalizing their costs or continue to watch the dollars flow out.

One other anomaly worth mentioning – investors are allocating to one area with higher than average fees, the liquid alts space. That said, it’s such a small pocket of the overall fund biz that it’s hardly worth mentioning at this point. Time will tell whether liquid alts can grow into a much large contributor to the industry and still maintain high internal expense ratios.

Source:

Investors Drive Expense Ratios Down (Morningstar)

2015 Fee Study: Investors Are Driving Expense Ratios Down (Morningstar)

The latest SPIVA mutual fund scorecard was released last week and it was more of the same from the past few reports — the majority of active mutual funds underperformed their respective benchmarks over the past 1, 3, 5 and 10 year periods.

These numbers are well-documented at this point so I’ll spare you the details. It can be difficult to keep up during a relentless bull market, so many active fund managers are hanging their hat on the fact that they can make up for this underperformance once the next bear market hits. This makes sense in theory and is one of the more appealing sales pitches for active management. Let’s see if this claim has any validity.

The following table comes from the 2008 SPIVA scorecard following the bloodbath that saw broad-based U.S. stock indexes fall anywhere from 31% to 44% in 2008 alone:

You can see that the majority of active mutual funds underperformed in the two previous bear markets. There was, however, a lone exception in both downturns — larger cap value funds. In 2008, nearly 80% of large cap value funds outperformed their benchmark while almost 65% outperformed in the 2000-2002 bear market.

This makes sense when you consider that most true value investors require a margin of safety when making a purchase. They don’t chase and overpay for expensive growth stocks. This type of a disciplined approach can pay off when other investors loosen up their risk management during a bull market. This is one of the reasons that value stocks are lagging behind growth stocks right now.

But investors can’t expect to outperform during every phase of the market cycle. As an extreme example, according to the 2009 SPIVA report, the top-performing U.S. equity mutual fund in 2008 ended up performing dead last in 2009 once the recovery took hold. This fund literally went from first to worst.

Obviously, actively-managed mutual funds don’t constitute the entirety of active portfolio management strategies and decisions. There are other ways of managing risk, including tactical asset allocation. Tactical asset allocation involves changing your asset class weights over time to account for the current environment, while a static asset allocation approach relies on sticking with a set target to each asset class with a rebalancing process to stay within the stated targets.

If you’re going to go down the tactical path you just have to ask yourself a few questions in advance:

Is my personality well-suited for a tactical asset allocation approach or is a static allocation better for my needs?

Do I have the requisite skills and knowledge to be able to accurately judge a tactical process?

Do I have the patience and discipline to actually follow and implement a tactical process?

Does the process in question rely a systematic rule-based strategy or is it based on the intuition of a professional investor?

There are no easy answers to these questions, but I would be skeptical of any advisor or portfolio manager that makes promises that they can get you out of the market before trouble hits and back in at the bottom with perfect timing. It’s possible to manage risk with your asset class exposures, but you can’t expect to fully sidestep all losses and fully participate in all gains.

Think about all of the people that called the financial crisis. Many pundits and investors who anticipated the real estate bust were heralded as geniuses by the media and investors alike. How many of those people have been completely wrong about the ensuing rally and economic recovery? Has anyone proven themselves completely reliable on both sides of the cycle?

All of which is to say that it’s never going to be easy. You can’t expect to have it all. Every investment style or strategy has its flaws. The trick is to find the one that you understand that gives you the best chance of minimizing your own flaws.

Source: SPIVA 2008

Further Reading: How to Preserve Capital During a Bear Market Not All Active Funds Consistently Underperform Why Value Investing Works

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This post from Ben Carlson (@awealthofcs) originally appeared on A Wealth of Common Sense.